Question

In: Finance

3. Payback Period - Concerning payback: a. Describe how the payback period is calculated, and describe...

3. Payback Period - Concerning payback:

a. Describe how the payback period is calculated, and describe the information this measure provides about a sequence of cash flows. What is the payback criterion decision rule?

b. What are the problems associated with using the payback period to evaluate cash flows?

c. What are the advantages of using the payback period to evaluate cash flows? Are there any circumstances under which using payback might be appropriate? Explain.

Expert Solution

Ans.

a) Payback period is the time required to recover the initial cash-outflow .

Steps to calculate Payback Period

First we have to determine the total initial capital investment (cash outflow)

Then we have to estimate the annual expected after-tax cash flows over the useful life of the investment.

If the cash flows are uniform then Payback Period = Total Initial Capital Investment / Annual expected after tax cash net cash flow.

And when cashflows are not uniform

The payback period shall be the period when total cash flows are equal to the initial investment.If the sum does not match then we have to compute the fraction of year.

According to given cutoff for payback period, the decision rule is to accept projects whose payback is before cutoff, and reject projects which tale longer time to payback.

b) The problems associated with using the payback period to evaluate cash flows are:

1. It ignores time value of money

2. It ignores cash flows which occur after the payback period

3. It gives more prefrence to short term projects over long term projects.

c) The advantages of using the payback period to evaluate cash flows are

1. It is very simple to compute.

2. It is in favour of short term project and liquidity.

3. It is easy to understand.

As this method considers liquidity, it may be appropriate while taking decision between short term projects where cash management is crucial.

jeff jeffy answered 2 years ago

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